Abstract:
“Everybody talks about financial innovation, but (almost) nobody empirically tests hypotheses about
it.” Frame and White (2004)
The financial turmoil from 2007 onwards has spurred renewed debates on the “bright” and “dark”
sides of financial innovation. Using bank-, industry-and country-level data for32 countries between 1996
and 2006, this paper is the first to explicitly assess the relationship financial innovation in the
banking sector and (i) real sector growth, (ii) real sector volatility, and (iii) bank fragility. We
find evidence for both bright and dark sidesof financial innovation. On the one hand, we find that a
higher level of financial innovation is associated with a stronger relationship between a country’s
growth opportunities and investment and GDP per capita growth and with higher growth rates in industries
that rely more on external financing.
On the other hand, we find that financial innovation is associated with higher growth volatility
among industries more dependent on external financing and with higher idiosyncratic bank fragility,
higher profit volatility and loan losses, as well as systemic banking distress. Finally, we find that
banks’ profitability was more negatively affected during the recent crisis in countries with higher
levels of financial innovation before the crisis.
